The Financial Accounting Standards Board is getting out of the business of recommending options-valuation models.
On Wednesday, FASB decided not to express its preference for a particular model for estimating the fair value of employee stock options when it writes its final standard on the issue. That’s a marked change from its stance in its proposed standard, in which FASB explicitly said it preferred a lattice model.
The board’s reasoning then was that a lattice model is preferable because it’s more fully able to capture and better reflects the characteristics of a particular employee share option in fair-value terms than closed-form models like Black-Scholes.
The lattice method uses a flexible framework that divides the time from an option’s grant date to its expiration date into small increments, which enables users to make adjustments reflecting expected volatility, share price, and other factors over time. The model takes into account many more assumptions about a grant’s features than the more rigid Black-Scholes formula.
FASB’s move comes as a response in part to word that the language in the standard was leading auditors to conclude that the lattice method was effectively a requirement. “We didn’t want to hog-tie individuals to a particular model,” said G. Michael Crooch, a FASB board member.
Many respondents to the proposal argued that the board should eliminate the explicit preference, partly because not all companies have the needed data for the more data-intensive lattice models. Other valuation experts argued that Monte Carlo simulation techniques and other valuation methods might be just as preferable to a closed-form model as a lattice model would be.
There are also emerging valuation models to consider. “My reaction was that we wanted the standard to be long-lived,” said Crooch. “As improvements came along, we wanted companies to move along the improvement line.”
In its final statement on stock-based compensation, 123R, FASB plans to provide only the basic six types of data it wants companies to use in arriving at the fair-value estimate. Crooch believes that the language in the final standard will change to require companies to use “the best method of the fair value.”
Still, FASB’s decision is tentative. The board has slated a September 15 public meeting with individuals from technology companies who want to propose new methodology for arriving at the best fair value for stock options.
Crooch acknowledged that the board’s decision may have “very little practical impact” because many companies that have the inputs may still find that the lattice method yields the best measure of fair value.